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Yieldco Basics: What Investors Need to Know

Here's the lowdown on this popular form of investment in the renewable energy segment.

You don't have to be a pie-eyed idealist to believe in renewable energy. It's increasingly contributing to the country's overall power generation, and should continue to be an important source in the coming years.

The development of the market has created more opportunities for investors. This is particularly true of a recent arrival on the publicly traded renewables scene, the yieldco. This is short for "yield company," and is an intriguing way to play the segment. Here are the important whats, whys, and hows of this type of security.

Pack and sellYieldcos are analogous to real estate investment trusts in the property sector, and master limited partnerships in the oil and gas business. Basically, they are collections of specialty assets that produce returns, the bulk of which are paid to investors in the yieldco.

Like MLPs, they are typically spinoffs of choice assets from larger energy companies -- the built-out, established, energy-producing facilities (usually powered by renewables) that are actively generating revenue. So basically, investors are buying into a completed network that brings in a steady flow of cash.

Much of which ends up in the investor's pocket. As with REITs and MLPs, usually a large chunk of a yieldco's earnings is distributed to shareholders in the form of dividends. These are generally treated as ordinary dividend income, although under certain circumstances -- like when a yieldco posts a loss -- they might qualify as return of capital (and therefore not taxable, at least up to the amount of the shareholder's original investment). .

A sunny investment ...As their name strongly implies, one of the yieldcos' great appeal to investors is their potentially high payouts. After all, theoretically their running costs are low and capital expenditures modest, so there should be plenty of cash rolling in to distribute to investors.

Wind power specialist Pattern Energy Group(NASDAQ:PEGI), for one, isn't shy about opening its wallet. It currently pays out at an annual rate of $1.34, for a healthy yield of 4.7%. NextEra Energy Partners' (NYSE:NEP) $1.40 clocks in at 3.6%.

Another advantage of yieldcos is that they are fully or nearly pure plays on green energy. Before they existed, investors couldn't put money directly into the renewables businesses of major energy companies. For example NextEra Energy(NYSE:NEE) -- from whence the eponymous Partners was spun off -- is a sprawling company that also operates fossil fuel and nuclear power plants.

Additionally, for fans of renewables a yieldco can be a less risky investment than other green energy stocks. Since renewables as a business are still relatively new, there is still much uncertainty about how the regulatory landscape will change, and what technologies will emerge from which companies. The business landscape is littered with the bones of once-promising solar and wind firms.

So there is still a bit of a casino market aspect to the segment; an investment in a yieldco -- backed by established, revenue-producing assets -- eliminates much of that uncertainty.

... or a dark sky?But as with any asset class, there are a few negatives to yieldcos. Taking the flip side of that last advantage, while investing in one can mitigate the risks associated with buying into the broader operations of a green energy firm, it can also miss out on the rewards.

Take an innovative company in the segment like SolarCity. It's crafted new ways not only of selling its solar panels, but also financing the production of these goods. Those choosing to allocate their renewables investment money on a yieldco instead won't benefit from any success SolarCity enjoys in those areas.

Additionally, energy production assets require piles of capital, a significant amount of time to build, and commitments from customers in order to become viable. Any one of a number of factors -- higher interest rates, increased competition in the given region, regulatory change, etc. -- could have an impact on results.

So that nice, steady revenue stream might start to run dry, while other types of renewable power investments gush ahead.

Blowing hot and coldSince yieldcos are a relatively recent innovation in the renewable energy segment, the jury is still out on whether their pluses outweigh their minuses.

True to their name and promise, their yields have generally been relatively high. Their stock performance, however, has been mixed.

The price of NRG Yield's (NYSE:NYLD) stock has nearly doubled in the company's young life, while NextEra Energy Partners' and Pattern Energy's have advanced in the low to mid-20% range since their IPOs. But TerraForm Power(NASDAQ:TERP) -- a spinoff of Sun Edison -- is down 5%.

Regardless, the yieldco is an intriguing entry onto the green energy investment scene. Those interested in direct plays in the segment should certainly consider them ... albeit with the above caveats firmly in mind.

Author

Eric has been writing about stocks and finance since the mid-1990s, when he lived in Prague, Czech Republic. Over the course of a varied career, he has also been a radio newscaster, an investment banker, and a bass player in a selection of rock and roll bands. A native New Yorker, he currently lives in Los Angeles.